Risks (Audit Risk Formula)
Component of Audit Risk
Inherent risk
Errors likely to occur
In client’s financial statements
Control risk
Errors that bypass controls
Errors not
detected by
controls
Detection risk
Errors caught by auditor
Errors undetected by auditor
Audit risk
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Different Types of Risk
Inherent Risk
The susceptibility of an account balance, disclosure or class of transactions,
considered at the assertion level, to a material misstatement, assuming there are no
related controls.
Control Risk
The risk that a material misstatement that could occur in an account balance,
disclosure or class of transactions, considered at the assertion level, will not be
prevented or detected and corrected on a timely basis by the client’s internal control
system.
Detection Risk
The risk that the auditors will not detect a material misstatement that exists in an
account balance, disclosure, or class of transactions assertion considered at the
assertion level.
Audit Risk
The risk that the auditors may unknowingly fail to modify our opinion appropriately on
financial statements that are materially misstated
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Types of risks: Inherent Risk
Inherent risk
►
It implies that auditors should attempt to predict where misstatements are most
and least likely in the FS segments (account or class of transactions).
►
Inherent risks is a measure of the likelihood that there are material misstatements
(errors or fraud) in a segment (class of transactions / account balance) before
considering the effectiveness of internal controls
Þ
At the start of the audit, there is nothing that can be done about changing the
inherent risk.
Þ
The auditor must assess the factors that make up the inherent risk and take them
into consideration when obtaining audit evidence.
Þ
Auditors begin their assessment of inherent risk during the planning phase and
update the assessment as the audit progresses.
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Types of risks: Control Risk
Control risk
The assessment of the likelihood that a misstatement that could occur and that
could be material will not be prevented or detected the internal control system.
Ideally, the control system would detect any material errors before they enter the
financial statements.
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Types of risks: Detection Risk
Detection risk
Is a measure of the risk that audit evidence (substantive procedures planned by the
auditor to detect material misstatements in the FS: tests of details of transactions,
tests of details of balances, and analytical procedures) will fail to detect
misstatements that could be material
è The Detection risk depends on other factors and is inversely related to the
accumulation of inherent and control risk
Combined Risk Assessment
è It determines the number of substantial elements of proof the auditor plans to
accumulate in order to reduce the Detection risk to an acceptable level.
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Audit Formula
The audit risk …
The audit risk is the ultimate acceptable
risk that material monetary errors are not
detected.
AUDIT RISK FORMULA
Inherent Risk
X
Control Risk
Combined Risk Assessment
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X
Detection Risk
=
Audit Risk
Combined Risk Assessment (CRA) Table
INHERENT
RISK
CONTROL RISK
RELY ON CONTROLS
NOT RELY ON
CONTROLS
(effective tests of controls)
(ineffective test of controls or
controls not tested)
LOWER
Minimal
Moderate
HIGHER
Low
High
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Relationship between Inherent, Control and
Detection Risk
Inherent Risk
Control Risk
lower
rely
higher
Combined Risk
Assessment
Detection
Risk
X
Minimal
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not rely
Audit Risk
=
Relationship between Inherent, Control and
Detection Risk
Inherent Risk
Control Risk
lower
rely
higher
Combined Risk
Assessment
Detection
Risk
X
Moderate
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not rely
Audit Risk
=
Relationship between Inherent, Control and
Detection Risk
Inherent Risk
Control Risk
lower
rely
higher
Combined Risk
Assessment
Detection
Risk
X
High
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not rely
Audit Risk
=
Relation between Risks & Roadmap
Planning and Risk
Identification
Client Acceptance and
Continuance
Strategy and Risk
Assessment
Execution
Conclusion and
Reporting
Identify Significant
Classes of
Transactions and
Related Applications
Design Test of
Controls
Prepare Summary of
Audit Differences
Understand Flows of
Transactions, WCGWs
and Controls
Execute Test of
Controls
Perform final audit
procedures
Perform Walkthroughs
Design substantive
audit procedures
Management Letter
Make Combined Risk
Assessments
Execute Substantive
Audit Procedures
Report
Understand clients
Business
Understand IT
Environment
Complexity and
Determine IT
Professional
Involvement
Identify Fraud Risks
and Determine
Responses
Determine Materiality
Inherent Risk
including Fraud X
Risk
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Control Risk X Detection Risk
=
Audit Risk